Alternatives To Fixed Deposits

FDs are financial instruments where an investor deposits a lump sum of money for a fixed period ranging from a few weeks to a few years and earns a pre-determined rate of interest. FDs are normally offered by banks. FDs from reputed banks are a very safe investment because such banks are carefully regulated by the Reserve Bank of India, RBI. On the other hand, the problem with fixed deposit is that it won't give you the same returns that you may get in the stock markets. For instance, a stock-portfolio may increase 20-30 per cent in a good year whereas a fixed deposit typically earns only 6-8 per cent. A fixed deposit also doesn't offer protection against inflation. If inflation rises steeply during the maturity of the FD, your inflation adjusted return will fall.

Tax implications

The interest income earned on a deposit is taxable at the same tax slab as the customer is in. It will be added to his income in the year under the head “Other Income”.

Alternative to FDs

Obviously mutual funds and stocks can offer higher returns but the main issue is whether there are low risk investment products which offer a better return than FDs. Some of the alternatives can be corporate FDs, Income Funds and Fixed Maturity Plans:

Corporate FDs

Corporate fixed deposits are similar to banking FD’s, except that the money invested is with a company and not a bank. Deposits under corporate FD’s are governed by the Companies Act under Section 58A.However, these deposits are unsecured.

The similarity between Bank FDs and Corporate FDs is that both have fixed tenures and have the same tax treatment. On the other hand, in the case of Corporate FDs since the investments are with private companies with no insurance protection, these investments are relatively riskier then bank fixed deposits and consequently offer better returns as well. Corporate FDs also have constraints in terms of the number of tenures that they offer deposits- usually short term deposits with 6 months and less are not found in company deposits.

Before investing in corporate FDs, an investor should look at the pedigree of the management and the fundamentals of the company. It is equally important to look at financial indicators like the interest coverage ratio, the debt-to-equity ratio and the free cash flow generated by the company. The interest coverage ratio will tell you whether the company can fulfill its interest obligations. Typically, look for a ratio of 2:1 and be skeptical of anything above this. Likewise, the debt-to-equity ratio of a company will tell you how leveraged the company is. One should also look at the credit ratings assigned to these companies.

If we compare the fixed deposit rates of State Bank of India with Tata Motors, we find that corporate FDs do provide more yield than bank FDs but of course you should look into the company profile before investing in them.

1 Year

2 Years

3 Years

State Bank of India

6.00%

6.50%

6.50%

Tata Motors

-

8.00%

8.75%

Mutual Funds (Income Funds)

There are two key disadvantages that one is faced with while investing in fixed deposits. One, fixed deposits are not very liquid. The investor cannot withdraw his money during the term of his deposit. In case he wants to make pre-mature withdrawal he has to pay a penalty. Second, fixed deposit schemes offered by most institutions today is such that the ‘real’ return that is earned is very low or actually negative i.e. the inflation rate is higher than the return on fixed deposits!

An alternative to fixed deposit can be mutual funds, especially the income funds. Mutual funds do away with one of the biggest drawbacks of fixed deposits i.e. liquidity. An investor can exit from the fund anytime he wants. Also the income funds rate low on risk and default. The returns offered by most of the well managed funds are higher than the company or bank deposits. Thus, an investor who is willing to take some risk or rather divert the risk associated with corporate deposit towards the income funds can enjoy the benefits of income funds as well.

Income Funds in India provide to the investors regular income and also stability of capital. Income Funds in India usually invest their principal in securities of fixed income such as government securities, bonds, and corporate debentures. There are many mutual funds houses that have launched Income Funds in India. The advantage of Income Fund is that it provides regular income to the investor either on a monthly or quarterly basis. Further the advantage of Income Funds in India is that it also provides stability of capital to the investor. The bonds that are there in Income Funds are usually of the investment grade. The other bonds are of such credit quality that they assure the protection of the capital.

If we compare the returns of some of the Income funds with that of fixed deposits, we find that in the long run, Income funds tend to do better. However, the below average return in last year for Income funds can be attributed to the recession. So, the future can be bright for short term too in case of Income funds as market is doing well.

Income Funds Vs Fixed Deposits

1-YR

3-YR

5-YR

INCEPTION

HDFC INCOME G

1.77%

9.12%

6.41%

8.24%

Birla Sun Life Income Plus – G

1.86%

11.54%

8.6%

10.43%

Canara Robeco Income-G

2.83%

13.6%

10.03%

9.24%

State Bank of India (Fixed Deposit)

6.00%

6.50%

7.25%

-

Fixed Maturity Plans

Fixed maturity plans are similar to FDs in that they have a pre-determined tenure (say 3 years like the maturity of an FD) ranging from a few weeks to a few years. The money is invested in fixed-income assets like certificate of deposits, commercial papers, money market instruments, corporate bonds; debentures of reputed companies or in securities issued by government of India and fixed deposits selected by the fund manager. These have lower risk of capital loss due to their investment in debt and money market instruments and are least exposed to interest rate risk as the fund holds the instruments till maturity getting a fixed rate of return. Here, fund managers primarily invest in AAA or such kind of good rated credit instruments with maturity profile of the securities in line with the maturity of the plan so there is also low credit risk with minimal liquidity risk involved. FMPs are schemes with a pre-specified tenure. The basic objective is to generate steady returns over a fixed period. Thus, investors are assured of returns if they stay in these products for the entire period.

Since these products are of different maturities, investors have the option of buying schemes that suit their requirements. FMPs have better tax efficiencies whether you invest in the short term or in the long term. The long-term capital gains (investment of more than a year) enjoy indexation benefit (Indexation is a technique to adjust income payments by means of a price Index , in order to maintain the purchasing power of the public after inflation).Importantly, if you stay invested for just over a year, there are double indexation benefits. For instance, if you buy an FMP of 14 months in February 2010, scheme will mature in April, 2011. In this case, the investor will get inflation indexation benefits for the years 2009-10 and 2011-12. So, the main advantage of FMP's is that you can take into account inflation while calculating your taxes which means that your after-tax return may be superior to FDs, especially if you lie in the top income tax bracket. In case of short-term capital tax, it is similar to interest income from bank fixed deposits. The returns are added to the income of the investor and taxed as per his/her slab.

The major drawback with FMPs is that the latter does not assure you any guaranteed returns. However, while buying it, one can look at the returns that are being offered at a particular time. Moreover, these schemes are not-so liquid since they have to be listed at the stock exchanges, exiting before the scheme matures is difficult.

FMP’s are investment options for sure if you want to park your money for short term. They are more tax efficient and give better post-tax returns. Though returns are not 100% guaranteed, they are almost risk free (remember almost). One may ask if FMP does really give better than returns then FD’s and practically as safe as FD’s why people don’t invest in these. The answer is that there is no awareness among people and they have less risk taking attitude.